“Reader’s Digest” Guide to QSBS Rollovers

For entrepreneurs, startup founders, and early-stage investors, Qualified Small Business Stock (QSBS) under Internal Revenue Code Section 1202 offers a powerful incentive: the potential to exclude a significant portion, or even all, of capital gains realized from the sale of eligible small business stock. This exclusion is designed to encourage investment in emerging companies, fostering innovation and economic growth. However, qualifying for the full Section 1202 exclusion generally requires holding QSBS for more than five years (updates as of 2025 have changed this requirement, but will not apply to most founders/shareholders until 2027 and beyond) , a timeline that does not always align with the pace of startup exits or the strategies of investors.

Section 1045, often referred to as the QSBS rollover provision, provides an important planning tool. It allows taxpayers to defer capital gains taxes on the sale of QSBS by reinvesting the proceeds into new QSBS. This flexibility is especially useful for investors who sell before the five-year mark or who realize gains that exceed the Section 1202 exclusion cap.

Section 1045 (QSBS Rollovers)

Section 1045 permits a taxpayer to defer recognition of capital gains from the sale of QSBS by reinvesting the proceeds into new QSBS. The gain is not eliminated, but the tax liability is postponed until the replacement QSBS is eventually sold. This provision was designed to recognize that the realities of business and investment often do not align neatly with the strict five-year holding period required under Section 1202.

To qualify for the rollover, the stock sold must have been held for more than six months. The proceeds must be reinvested into new QSBS within sixty days of the sale, which is a firm deadline. The replacement stock must meet all of the eligibility requirements of QSBS under Section 1202 at the time of issuance, including being issued by a domestic C corporation with no more than fifty million dollars of gross assets immediately after the issuance. The corporation must also satisfy the active business requirement during substantially all of the investor’s holding period. Many practitioners treat six months as a practical safe harbor, but maintaining active operations for longer strengthens the investor’s position.

When the rollover is executed, the taxpayer must make a timely election on their tax return. The basis of the replacement stock is reduced by the amount of deferred gain, ensuring that the gain will ultimately be recognized upon sale. A valuable feature of Section 1045 is the tacking rule, which allows the investor to add the holding period of the original stock to that of the replacement stock. This makes it possible to continue accumulating time toward the five-year requirement for the Section 1202 exclusion.

Ways to Reinvest

There are several ways to reinvest under Section 1045. Some investors purchase stock in an existing qualified small business that is not affiliated with them. This is often the simplest approach, provided the issuer clearly meets the requirements. Others choose to form a new corporation and fund it with the proceeds. This corporation might pursue startup activities or research and development, but it must actively conduct a qualified trade or business from the outset.

A third option is to form a corporation for the purpose of acquiring an existing active business. This strategy allows investors to use the rollover to facilitate acquisitions. A more complex approach is to reinvest through a partnership or limited liability company that purchases replacement QSBS. Because Section 1045 applies at the individual partner level, strict allocation and timing rules must be followed. This structure generally requires careful work with tax counsel.

It is important to emphasize that reinvestment must be into actual stock. Instruments such as convertible debt or SAFEs do not generally qualify.

Substantiation and Documentation

Successfully claiming the benefits of Section 1045 and Section 1202 depends heavily on documentation. The burden of proof rests with the taxpayer if the IRS challenges a rollover or a later exclusion. Investors must be able to show that the original stock qualified as QSBS, that it was held for more than six months, and that proceeds were reinvested within the sixty-day window. Records of both the sale and the reinvestment are essential, and investors should be able to produce evidence such as wire transfers or bank statements showing capital contributed to the new issuer.

For replacement stock, eligibility at issuance must also be substantiated, including the gross asset test and the active business requirement. The 80 percent test, which requires that a corporation use at least 80 percent of its assets in the active conduct of a qualified trade or business, is a key part of this analysis. If the issuing corporation is controlled by the taxpayer, contemporaneous documentation of business activities is especially important.

Issuers of replacement stock can make this process easier by providing representations that confirm their eligibility and their commitment to maintain compliance.

Near-Term and Long-Term Benefits

The near-term benefit of Section 1045 is the deferral of capital gains tax. Instead of paying tax immediately, investors can reinvest proceeds and keep capital at work. This is particularly useful for early exits, when stock is sold after six months but before five years, and for situations where investors want to shift capital from one business into another without triggering immediate tax.

The long-term benefit is the preservation of Section 1202 exclusion opportunities. Thanks to the tacking rule, time spent holding the original stock counts toward the five-year requirement for the replacement stock. An investor who holds QSBS for two years, sells, and reinvests into new QSBS can qualify for the exclusion after three additional years. Section 1045 does not create a new exclusion for the same gain, but it allows excess gains above the Section 1202 cap to be redeployed into new stock. This redeployment can create fresh exclusion opportunities, which is particularly valuable for serial entrepreneurs and active angel investors.

Summary

Section 1045 QSBS rollovers offer a sophisticated strategy for business owners and investors seeking to maximize the benefits of QSBS. By understanding how the rollover works, carefully choosing reinvestment paths, and maintaining thorough documentation, taxpayers can defer capital gains, preserve long-term Section 1202 benefits, and continue investing in the small business ecosystem.

Because the rules are complex and the compliance burden significant, consulting with tax professionals experienced in QSBS planning is strongly recommended to ensure compliance and capture the full advantage of this provision.